Chasing the Biggest Stocks Part 2

Earlier this year we wrote an article on the risks of buying a blue-chip stock that has recently become one of the 10 largest companies on the stockmarket - https://loricapartners.com.au/insights/think-twice-about-chasing-the-biggest-stocks

The research shows that once a stock reaches the Top 10, its performance over the following 5 and 10 years underperforms the market (on average).

Ben Carlson recently wrote an article expanding on this research, focusing on the S&P 500 index in the U.S, which tracks around 500 of the largest U.S listed companies.

First some context. The biggest US listed stocks are really big. The top 25 companies in the S&P 500 are as big as the rest of the index combined, as shown below:

S&P 500 Market Caps Ranked

Source: Ritholtz Wealth Management as of 17 June 2024

The biggest stocks also have the highest valuations as measured by Price/Earnings (PE) ratios. The graph below shows PE ratios by decile, with the largest stocks on the right hand side:

As Ben notes, there is a reason the biggest stocks have a valuation premium over the rest of the market. They’ve earned it. These companies have continued to innovate and grow at levels we’ve never seen before at this scale and that’s been reflected in their returns.

Now, let’s look at the performance of the S&P 500 by decile over the past five years to June 2024:

Source: Ritholtz Wealth Management as of 18 June 2024

Five years is a short time period when investing in the stockmarket, but the most recent results do show the biggest companies have had the best returns while the smallest companies have been left behind.

Conclusive? In reality, no.

The above graph shows the trailing returns for the current biggest stocks, not necessarily the biggest stocks five years ago.

Some of the big stocks of today were smaller five years ago. Some of the smaller stocks today were bigger five years ago.

Five years ago, Nvidia was outside the top 60 stocks in the S&P 500. Three years ago, it had just barely cracked the top 10 list of names with an S&P 500 weighting of just 1%. Today, Nvidia makes up more than 7% of the index and is neck and neck with Apple and Microsoft as the largest stock in the entire market.

If we do the same analysis but look at the returns by decile based on the size of these companies five years ago as the starting point:

The largest stocks from five years ago still have impressive returns but the top performer was the smallest decile of companies in the S&P 500.

In theory, smaller companies have more room to grow because they haven’t yet reached their full scale.

It’s actually out of the ordinary for the biggest stocks in the index to outperform. Over the past 100 years, small stocks have outperformed large stocks by approx. 2% per annum - but this premium is not evident every year. The Nobel prize winning research Lorica Partners uses as a building block of our client portfolios recognises:

Growth companies (or stocks with high PE ratios) can be expected to have lower returns compared to value or cheap stocks (with lower PE ratios); and
Small company stocks have higher expected returns compared to large company stocks because they are riskier to hold, and higher risk equates to higher returns.

In recent times, large cap stocks have outperformed small stocks, driven partly by differences in sector composition. Large technology stocks, and specifically the ““Magnificent Seven” group of mega-cap tech stocks, account for much of the stockmarket gains.

However, the research still confirms that over the longer term, the best time to buy stocks is before they reach the top 10.

Outperformance comes from the journey to the top 10, which can be breathtaking. However, once these companies reach the summit, it’s much harder to maintain that outperformance.

As Warren Buffett once noted, “Size is the enemy of outperformance.”

Author: Rick Walker

Source: Chasing the Biggest Stocks - A Wealth of Common Sense